It’s an opportunity born of neglect. Small-cap stocks have historically been the star performers of equities, handily outpacing large-cap stocks. And because they can get lost so easily in the grand sweep of the markets, small companies are often misunderstood and mispriced. That makes them great sources of alpha potential, especially for investors who take the time to get to know them well.

By expanding the playing field, active SMID-cap investing, which unites the faster growth of small-cap companies with the higher quality of midsize firms, offers the robust return potential of small stocks, but with less volatility and fewer of the constraints associated with small-cap-only strategies.

Like their smaller peers, SMID-caps aren’t as well followed or understood as big stocks. The typical stock in the Russell 2500 Index (the most widely used proxy for the SMID-cap category) is covered by only eight sell-side analysts, versus 13 for the typical large-cap Russell 1000 Index stock. Even those that get coverage don’t get much. As measured by a mindshare index—which tallies the average number of earnings-estimate changes per analyst and the number of each broker’s published research notes—large-cap stocks got nearly four times more research attention than SMID-cap stocks (Display).

(click to enlarge)Because the information flow is so thin, it is easy for the market at large to overlook smaller companies or to have an incomplete—even faulty—view of their prospects. This knowledge deficit is most obvious in the variation around consensus earnings-per-share estimates, which has been nearly 45% greater for Russell 2500 companies than for Russell 1000 companies over the past 20 years.

Wider differences in forecasts have contributed to greater dispersion in SMID-cap returns—and more risk versus large-cap stocks: the potential upside is larger, but so is the potential downside. Over the past decade, the best-performing Russell 2500 stocks averaged a total return of roughly 98%, beating the best-performing Russell 1000 stocks by 14 percentage points; however, the SMID index’s losers fell 35% over that same period, trailing the large-cap losers by 11 percentage points.

But the scarcity of coverage and wider range of potential outcomes also make the SMID realm a rich hunting ground for active managers, especially if they have the experience and research capabilities to flush out opportunities in smaller companies that others may be missing. In the pursuit of SMID alpha, however, dodging disasters is at least as important as picking winners, so forecast accuracy is critical. As the display below shows, smaller companies are punished more severely for earnings disappointments than they are rewarded for upside surprises. The stakes just aren’t as high for big stocks.

(click to enlarge)

Judging from history, active SMID managers have done a good job of beating the odds. Since 1990, the median SMID-cap manager has delivered an annualized return of 12.3%, outperforming the Russell 2500 by 200 basis points. Although the median active SMID portfolio has achieved these gains with more volatility than the index, it has more than adequately compensated for this added risk, as reflected in its superior risk-adjusted return, or Sharpe ratio, which has averaged 0.44, versus 0.35 for the median large-cap manager. The SMID domain has historically been profitable for both growth and value styles. By casting a wider net, SMID-cap investing offers an appealing alternative to small-cap-only strategies for capturing the big potential in small stocks.

Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

Bruce K. Aronow is Team Leader and Portfolio Manager/Analyst—US Small/SMID Cap Growth Equities and James MacGregor is Chief Investment Officer—US Small and Mid-Cap Value Equities at AllianceBernstein.

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